Creative Liquidity Strategies to Address Liability and Exposure
Economic dislocation associated with COVID-19 continues, and organizations seek to overcome these challenges. While the S&P and NASDAQ hit new highs, businesses struggle for runway. Owners, including private equity owners, face challenges, but — as they say — from challenges come opportunities. Creative strategies can allow companies to emerge stronger and better positioned. Maximizing liquidity and minimizing exposure to management anchor any strategy ensuring potential liabilities are covered, businesses are well positioned for the road ahead and everyone is protected from unanticipated disappointments.
Government support and lender accommodations are now eroding. To date, government support has been key to many challenged business’ survival plans, but is likely coming to an end. Further, most private equity-sponsored companies are not eligible to participate under the SBA’s affiliation rules. Now, many lenders have lost their appetite to further “amend and extend.”
Businesses need plans in place to manage their liquidity needs themselves. We have seen increasing use of equity infusions, borrowings, sale of non-core assets, out of court restructurings, selective defaults and in some cases, consensual foreclosures, assignments for the benefit of creditors or Chapter 11 restructurings.
One example of such a strategy, which many companies have implemented or are in the process of evaluating, is an asset dropdown transaction, which can enhance liquidity. In an asset dropdown transaction, a company transfers assets to a newly-created subsidiary that is not a loan party covered by the company’s existing lending facility (typically a foreign or unrestricted subsidiary). This subsidiary may then sell the transferred asset or borrow money against it with new cash often free of existing liens. The result of the transaction makes new value available for business purposes. While negatively affected creditors may challenge such transfers under the loan documents or seek to unwind the transaction, if properly structured, these transactions can be defended.
Putting best practices in place can position the company (and its owners) to defend these transactions. Many companies appoint independent directors to the newly-formed subsidiary to provide independent business judgment to the transactions. Independent opinions valuing the transferred assets support the validity of the transactions. In addition, through proper structuring it is also possible to take advantage of certain safe harbors available under the Bankruptcy Code to protect sophisticated financing transactions. Transactions like these have made hundreds of millions of dollars available to companies in situations where the government and lenders refuse to permit sufficient liquidity.
This is just one example of liquidity strategies being employed now. As private equity firms and business owners execute ever more aggressive structures, they must remain attuned to potential control person liabilities that arise if such strategies are ultimately unsuccessful and the business fails. There are two sets of liabilities to manage. First, direct statutory liability exists for failure to protect and pay over “trust fund” taxes or for certain employee or environmental claims. Second, claims can arise from alleged failure to properly manage the business.
The first risks, express, statutory liabilities to control persons, consist of statutes governing taxes, employee benefits, payroll obligations and environmental impact that impose direct liability on shareholders, officers and directors. These claims arise suddenly and unexpectedly, and often carry significant penalties. Some, such as failure to pay impounded taxes or provide for environmental remediation, can even carry criminal penalties. Managers must put controls in place to ensure payment of such obligations regardless of the outcome. This is particularly critical where defaults under a company’s credit facility could allow the lenders to eliminate access to cash while claims go unpaid.
The other risks relate to claims that a company’s control persons breached fiduciary duties to the company. Where a board is populated with shareholder representatives (common in private equity structures), unpaid creditors can argue that control persons failed to protect their interests and seek personal liability. This requires careful attention to best practices, involving independent attorneys and advisors, independent board members, and maintaining robust insurance. Well-recognized procedures such as chapter 11, assignments for the benefit of creditors or cooperative foreclosures can also provide significant protection.
Companies and their managers will be grappling with enterprise-threatening fallout from the global pandemic. They need to think carefully about using all the tools in the shed to protect their businesses and themselves.
Sam Newman and Vijay Sekhon are partners at Sidley Austin LLP